The FDR Framework is the backbone for a 21st century financial system. Under this framework, governments ensure that every market participant has access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to analyze this data because they are responsible for all gains and losses.

Wednesday, May 29, 2013

What can be done to end what the BoE's Andrew Haldane calls the "irresistible" urge to bailout banks?

The Wall Street Journal reports that the Bank of England's Andrew Haldane acknowledge the elephant in the room when he observed that financial regulators face an "irresistible" urge to bail-out banks using taxpayer funds rather than bail-in banks using stockholder and unsecured debt holder funds.

Mr. Haldane called for a set of binding rules on authorities to "tie their hands" and force them to bail-in rather than bail-out the banks.

In addition, he wanted higher levels of capital to make it more likely that at a time of crisis the authorities would not ask that the rules be taken off and that the capital on bank balance sheets actually be used.

History has already shown that neither of Mr. Haldane's proposed solution to the irresistible urge has proven to be effective.

Bank regulators will never give up the option of using taxpayer funds to bail-out the banks in a time of financial crisis. Even if a law is passed today, everyone knows that the law will be repealed if the bank regulators think that the failure to repeal the law will make the financial crisis worse.

Bank regulators also will never require banks to use their book capital to absorb losses during a financial crisis. Bank regulators see a decline in book capital levels as sending the wrong signals about the safety and soundness of the financial system. The bank regulators would rather engage in regulatory forbearance and let banks practice 'extend and pretend' to turn non-performing loans into 'zombie' loans.

Your humble blogger calls the banking regulators' "irresistible" urge to bail-out the banks using taxpayer funds the elephant in the room because this urge results from opacity.

Because banks are opaque, in Mr. Haldane's words they are 'black boxes', market participants do not know how risky they are.

As a result, market participants rely on bank regulators who have 24/7/365 access to each bank's exposure details to assess and communicate the risk of each bank.

The failure to properly assess or communicate the risk of each bank results in market participants having more exposure to each bank than they can afford to lose. It is this excess exposure framed as financial contagion that assures that banks will always be bailed-out by taxpayers.

Regular readers know that there is one simple solution that ends the bank regulators' irresistible urge to bail-out the banks. Require the banks to disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this information, market participants are no longer dependent on the bank regulators' assessment and communication of the risk of each bank. Rather, market participants can independently assess the risk of each bank and adjust their exposure to what they can afford to lose given the risk of each bank. This ends the fear of financial contagion.

In addition, with transparency, unsecured debt and equity investors expect to be held responsible for absorbing losses on their investments. The investors know they face the potential for loss and they have an incentive to exert restraint on bank management so that bank management does not take on excessive amounts of risk.

This is the way our financial system operates under the FDR Framework.

With financial contagion eliminated and investors expecting to absorb losses, there is no reason for bank regulators to still have an irresistible urge to bail-out the banks.

Rules that force a bank's creditors to lose money, rather than the taxpayer, may be insufficient to address the problem of banks being too big to fail, said Andrew Haldane, the Bank of England's executive director for financial stability Tuesday.

"Faithful implementation" of the regulatory reform agenda that has been pursued in stages since the financial crisis of 2008 is "an absolute necessity," said the BOE official at a conference here on the future of the banking sector. He said, however, that such a move is "necessary, but perhaps not sufficient."

The central banker said, "when a big bank fails, bail in is never a soft option...the temptation is always there for governments to reach for the check book," referring to when creditors are forced to take losses. He said the temptation to bail out rather than bail in was "irresistible."

Mr. Haldane said that to get past this problem authorities needed to have set rules that "tied their hands" and that tougher capital standards for banks should be considered. He referenced a proposal in the U.S. to up the leverage ratio for some banks to 15%, rather than the 3% envisaged in international rules known as Basel III.

"I don't have a magic number, but I do think the time is right within Europe to reopen the debate about whether 97%-debt financed banks is a suitably proved endpoint," he said.

About this blog

A blog on all things about Wall Street, global finance and any attempt to regulate it. In short, the future of banking and the global financial system.

This blog will be used to discuss and debate issues not just for specialists, but for anyone who cares about creating good policies in these areas.

At the heart of this blog is the FDR Framework which uses 21st century information technology to combine a philosophy of disclosure with the practice of caveat emptor (buyer beware).

Under the FDR Framework, governments are responsible for ensuring that all market participants have access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to use this data because under caveat emptor they are responsible for all gains and losses on their investments; in short, Trust but Verify.

This blog uses the FDR Framework to explain the cause of the financial crisis and to evaluate financial reforms like the ABS Data Warehouse.